Options on futures contracts

[FlorenceCC]

Hi David,

I was wondering if you could give an example of how an option on a futures contract would work concretely? I am having a hard time figuring out what are the actual steps on this one.
Let's say we have a call for instance - is the strike price the same as the price of the underlying futures contract at the time we buy our option?
If we exercise the option and receive as payoff the excess of the futures price over the strike price, what do we do with our long position in the futures contract, and do we make another profit when we offset it, if the price of the futures contract at maturity is higher than it was when we bought the option.
I apologize, as you can see I am very confused on this. Particularly I think grasping the disctintion between the payoff on the futures contract vs. payoff on the option itself.

Thank you David

Florence

 

[David Harper CFA FRM]

Hi @FlorenceCC I copied Hull's explanation from Chapter 18, see below. When we enter a long position in a futures contract, the delivery price, K, which sometimes I call the strike price of a regular (non-option) futures contract is equal to the then-prevailing futures price; i.e., at futures contract inception, K = F(0). But with respect to an option on a futures contract, the option strike price can be any value. Then when it comes time to exercises, the option holder is simply paid the gain (if any) or "difference" between the option's strike and the then-prevailing F(0). How I think of this is: for a long position, this is just like closing out the contract "as if" it were entered at the strike price and cash settled to close it out; then a new futures contract is entered at the current futures price. Think stack and roll. It's just like that except that the original trade wasn't an (FMV = 0) long at the prevailing F(0) but rather the delivery price was fixed as some arbitrary strike price, K. Put another way, a regular trade is K = F(0), but an option on a futures contract is to pay the option premium for arbitrary K. Then exercise is like closing this out for cash settlement and "rolling" into a new FMV futures contract. Re: the new long position: it's a regular futures contract, so it can be closed out or held to maturity (delivery). I hope that helps!

Hull explaining future options:

"18.1 NATURE OF FUTURES OPTIONS: A futures option is the right, but not the obligation, to enter into a futures contract at a certain futures price by a certain date. Specifically, a futures call option is the right to enter into a long futures contract at a certain price; a futures put option is the right to enter into a short futures contract at a certain price. Futures options are generally American; that is, they can be exercised any time during the life of the contract. If a futures call option is exercised, the holder acquires a long position in the underlying futures contract plus a cash amount equal to the most recent settlement futures price minus the strike price. If a futures put option is exercised, the holder acquires a short position in the underlying futures contract plus a cash amount equal to the strike price minus the most recent settlement futures price. As the following examples show, the effective payoff from a futures call option is max(F - K, 0) and the effective payoff from a futures put option is max(K - F), where F is the futures price at the time of exercise and K is the strike price.

Example 18.1 Suppose it is August 15 and a trader has one September futures call option contract on copper with a strike price of 320 cents per pound. One futures contract is on 25,000 pounds of copper. Suppose that the futures price of copper for delivery in September is currently 331 cents, and at the close of trading on August 14 (the last settlement) it was 330 cents. If the option is exercised, the trader receives a cash amount of

25,000 * (330 - 320)cents = $2,500

plus a long position in a futures contract to buy 25,000 pounds of copper in September. If desired, the position in the futures contract can be closed out immediately. This would leave the trader with the $2,500 cash payoff plus an amount

25,000 * (331 - 330)cents = $250

reflecting the change in the futures price since the last settlement. The total payoff from exercising the option on August 15 is $2,750, which equals 25,000*(F-K), where F is the futures price at the time of exercise and K is the strike price.

Example 18.2 A trader has one December futures put option on corn with a strike price of 600 cents per bushel. One futures contract is on 5,000 bushels of corn. Suppose that the current futures price of corn for delivery in December is 580, and the most recent settlement price is 579 cents. If the option is exercised, the trader receives a cash amount of

5,000 * (600 - 579)cents = $1,050

plus a short position in a futures contract to sell 5,000 bushels of corn in December. If desired, the position in the futures contract can be closed out. This would leave the trader with the $1,050 cash payoff minus an amount

5,000 * (580 - 579)cents = $50

reflecting the change in the futures price since the last settlement. The net payoff from exercise is $1,000, which equals 5,000*(K - F), where F is the futures price at the time of exercise and K is the strike price." -- Hull, John C.. Options, Futures, and Other Derivatives (Page 382). Pearson Education. Kindle Edition.​

 

[FlorenceCC]

Hi David,

It's perfectly clear now, thank you very much. I very much appreciate the time you take to answer so many questions, and in a way that always make concepts so clear. Really. I don't know how I'd study without BT.

Kind regards.